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ADVISORY ON INTEREST RATE RISK MANAGEMENT

The response to target rate increases was positive and significant at all maturities, but smaller at the long end of the yield curve: a one percentage point increase in the Fed funds target led to an increase of 55 basis points in the three-month T-bill rate, but only a 10 basis point increase in the 30-year bond yield. Recognizing that some Fed actions may have been anticipated, Cook and Hahn also examined the relationship between changes in interest rates and future changes in the target. They found little evidence that the target rate changes were anticipated at a one- to two-day horizon, however | ADVISORY ON INTEREST RATE RISK MANAGEMENT January 6 2010 The financial regulators1 are issuing this advisory to remind institutions of supervisory expectations regarding sound practices for managing interest rate risk IRR . In the current environment of historically low short-term interest rates it is important for institutions to have robust processes for measuring and where necessary mitigating their exposure to potential increases in interest rates. Current financial market and economic conditions present significant risk management challenges to institutions of all sizes. For a number of institutions increased loan losses and sharp declines in the values of some securities portfolios are placing downward pressure on capital and earnings. In this challenging environment funding longer-term assets with shorter-term liabilities can generate earnings but also poses risks to an institution s capital and earnings. The regulators recognize that some degree of IRR is inherent in the business of banking. At the same time however institutions2 are expected to have sound risk management practices in place to measure monitor and control IRR exposures. Accordingly each of the financial regulators have established guidance on the topic of IRR management see Appendix A . Although the specific guidance issued and the oversight and surveillance mechanisms used by the regulators may differ supervisory expectations for sound IRR management are broadly consistent. The regulators expect all institutions to manage their IRR exposures using processes and systems commensurate with their earnings and capital levels complexity business model risk profile and scope of operations.3 Effective IRR management processes are particularly important for those institutions experiencing downward pressure on earnings and capital due to lower credit quality and market illiquidity. This advisory re-emphasizes the importance of effective corporate governance policies and procedures risk measuring and